Thursday, February WRM# TOPIC: Tax Law Changes Reinvigorate Grantor Retained Annuity Trust (GRAT) Planning.

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1 Thursday, February WRM# The WRMarketplace is created exclusively for AALU Members by the AALU staff and Greenberg Traurig, one of the nation s leading tax and wealth management law firms. The WRMarketplace provides deep insight into trends and events impacting the use of life insurance products, including key take-aways, for AALU members, clients and advisors. TOPIC: Tax Law Changes Reinvigorate Grantor Retained Annuity Trust (GRAT) Planning. MARKET TREND: Zero-gift planning techniques, like zeroed-out GRATs, have taken on renewed importance in legacy planning as a way to both remove assets from the estate and to preserve the federal unified credit to attain the maximum step-up in income tax basis at death. SYNOPSIS: The zeroed-out GRAT transfers wealth on a transfer tax-efficient basis simply by outperforming a set investment hurdle rate. GRATs also complement life insurance planning as exit funding strategies for split dollar life insurance arrangements. Since GRATs only transfer an asset s appreciation, however, the technique s success relies heavily on the numbers, including the applicable investment hurdle rate (the so-called 7520 rate ), the projected and actual annual investment returns on trust assets, the availability of valuation discounts on transferred assets, the ability to delay or backload annuity payments, etc. Several features distinct to GRATs create unique opportunities for post-transaction management of the trust s performance, which enhance the GRAT s probability of success. TAKE AWAYS: GRATs, as a zero-gift planning strategy, currently benefit from their codified status under the Treasury Regulations and their unique flexibility with regard to term selection and annuity payment structure. Post-transaction management and performance reviews, however, are critical to taking a GRAT plan to the next level. GRATs must be monitored annually to review the performance of the underlying assets, the potential risk of the grantor s death during the term, and the corresponding need to make changes to the investments, such as by exercising a power of substitution to lock-in existing growth. Zeroed-out GRATs transfer wealth on a transfer tax-efficient basis simply by outperforming a set investment hurdle rate. GRATs also complement life insurance planning as exit funding strategies for split dollar life insurance arrangements. Several features distinct to GRATs create unique opportunities for post-transaction management of the trust s performance, which enhance the GRAT s probability of success (see attached summary chart of highlighted features/options). 1

2 THE FUNDAMENTALS A GRAT is a codified 1 estate freeze strategy where a grantor transfers assets to a trust and retains the right to receive an annual annuity payment for a specified period (e.g., a term of years). At the end of the term, the trust remainder passes to the grantor s designated beneficiaries, without imposition of estate-tax. The annual annuity may be set as a fixed dollar amount or expressed as a fixed percentage of the trust's initial value, with the calculation of the actual annuity amount based on a federally-set, monthly adjusted interest 7520 rate. Generally, to transfer wealth to the trust s remainder beneficiaries, the assets must appreciate more than the 7520 rate set for the month of the GRAT s creation. The grantor also must survive the GRAT term to avoid inclusion of some or all of the GRAT assets in his or her taxable estate. THE BASIC STRUCTURE: ZEROED-OUT GRAT A GRAT will be most efficient for gift and estate tax purposes if the grantor zeros-out the gift tax value of the GRAT s remainder interest (i.e., the present value of the annuity stream equals the fair market value of the assets transferred to the trust), which avoids a taxable gift upon funding. 2 Creating a GRAT that results in anything more than a nominal taxable gift will not only fail to provide additional benefit, but also may result in wasted gift tax payments or federal unified credit. For example, if assets in a taxable GRAT fail to provide a rate of return equal to the 7520 rate, part or all of the property gifted to the GRAT will return to the grantor as part of the annuity payments. THE BELLS & WHISTLES: ENHANCING GRAT PERFORMANCE Since GRATs seek only to transfer asset appreciation beyond a specified hurdle rate, the technique s success relies heavily on the numbers -- e.g., the applicable 7520 rate, the assets used for funding, the annual projected and actual rate of return on the trust, the availability of valuation discounts, the ability to delay or backload annuity payments, the continuation of grantor trust status after the GRAT term, etc. These features provide GRATs with significant optionality to enhance their overall performance. Annuity Payment Options Increasing or Backloaded Annuity Payments. GRAT annuity payments may be structured to increase each year by up to 20% of the prior year s payment. Generally, increasing annuity payments will generate a larger GRAT remainder if the property transferred appreciates at a relatively constant rate over the GRAT term. Example: Assume a 5-year, zeroed-out GRAT is funded with an initial contribution of $3 million, and the 7520 rate is 2.2%. The grantor anticipates 5% annual growth. If the GRAT makes level annuity payments, approximately $290,000 passes to the remainder beneficiaries. If the annuity payments increase each year by 20%, this remainder increases to $326,000. Increasing annuity payments will have appeal for GRATs involving hard-to-value or illiquid property that will initially generate little to no cash flow (e.g., closely-held stock). In this case, to avoid in-kind distributions, the GRAT can be funded with sufficient cash to meet the smaller initial annuity payments until the occurrence of an expected liquidity event. 3 2

3 105-Day Delayed Annuity Payments. Generally, a GRAT has up to 105 days following the GRAT s anniversary date to make the annual annuity payment. 4 This allows the GRAT to take advantage of an additional three months of compounding or dividend payments on those assets before distribution. Valuation Adjustment Mandatory Valuation Adjustment. If a GRAT annuity is structured as fixed percentage of the trust s initial value and the trustee incorrectly values the trust assets, the GRAT must require the trustee to make a compensating payment to the grantor within a reasonable time of the valuation adjustment. 5 In other words, GRATs have a regulatory-sanctioned formula valuation clause. This can provide protection from exposure to unexpected gift tax liability due to IRS valuation challenges. This feature may be particularly pertinent for planning with hard-to-value or discountable assets (e.g., real property, closely-held business interests, etc.) as the IRS continues to challenge the use of formula valuation clauses in other planning techniques (such as direct gifts and installment sales to grantor trusts). Valuation Discounts. Transferring discounted assets to a GRAT can significantly enhance the probability that the GRAT assets will out perform the 7520 rate. Example: 6 Grantor funds a 10-year, zero-out GRAT with public stock worth $1 million, subject to a 15% blockage discount that results in a $850,000 value for federal gift tax purposes. The annuity payments are based on $850,000 and will increase by 20% each year. The 7520 rate is 2.2%. No discount will apply to the value of any stock distributed to satisfy the annuity payments (as the number of shares distributed will be insufficient for a blockage discount). The discounted transfer immediately produces an initial remainder value of $150,000 ($1,000,000 - $850,000). Now, for the GRAT to pass that amount to the beneficiaries at the end of the term, it must only achieve an annual return of 1.8% (0.4% less than the 2.2% 7520 rate). If the GRAT s performance simply matches the 7520 rate, it will pass $186,000 to the remainder beneficiaries (rather than $0 with undiscounted assets). If the GRAT s investment performance equals 5% annually, the GRAT will pass $473,000 to the remainder beneficiaries (compared to $269,000 with undiscounted assets). The benefit of discounting, combined with the GRAT s inherent valuation adjustment feature, makes valuation discounts a very powerful add-on to GRAT planning. But advisors must factor in the flip-side of discounts, particularly if the GRAT will need to make in-kind distributions of the transferred assets to satisfy the annuity payments. In-kind distributions will require annual valuations, which can be time-consuming and expensive for hard-to value assets. In addition, property subject to a discount going into the GRAT incur a discount coming out. This will undermine the planning benefits, particularly if the discount applied to the annuity distributions is cumulatively larger than applicable to the initial transfer (e.g., the transfer of a controlling business interest into a GRAT receives no discount, but annuity distributions from the GRAT of a smaller percentage of those interest triggers a minority discount). Thus, advisors and clients must proceed carefully when combining GRATs and valuation discounts. Term Selection. Currently, a grantor can create a GRAT for a term as short as two years or as long as the grantor s life expectancy. The choice of the term will depend on several issues, including the type of assets contributed, their projected performance, the grantor s life expectancy, etc. 3

4 Long-term GRATs. Longer-term GRATs may offer significant benefits for planning with consistently high return assets, such as high-dividend paying stock. The longer term can lock in a low 7520 rate and will require smaller annual payments, which allows the GRAT to maximize the benefits of compounding growth. A longer-term also may be preferred if the client wants to shift the expected appreciation in non-marketable assets that will not produce significant initial liquidity (e.g., interests in a closely-held business that anticipate a future sale). Short-term and Declining GRATs. When funding with more volatile assets, however, long-term GRATs may face a higher probability of failure, since periods of asset growth can be countered by periods of depreciation. If a client wants to capture an asset s volatility, a series of short-term GRATs can have a smoothing effect from a return perspective, by capturing interim investment volatility and avoiding offsetting periods of growth and depreciation. Short-term GRATs also hedge against the mortality risk of the grantor s death during the term. Example: 7 A Monte Carlo simulation (a statistical analysis that runs thousands of simulations) compares the performance of a single 10-year, zeroed-out GRAT to a series of 10 one-year, zeroed-out GRATs. The initial contribution is an asset worth $1 million with an anticipated 8% annual return and a standard deviation of 30% (typical of individual stocks). The initial 7520 rate of 3.8% increases each year by.5% (ending at 8.8% in year 10). Based on these assumptions: The ten-year GRAT has a 36% chance of transferring $0 to the remainder beneficiaries and a 48% chance of transferring $500,000 or less, with only a 17% chance of transferring more than $3 million. A series of one-year GRATs has a 94% chance of transferring between $500,000 to $2 million to the remainder beneficiaries, with a very low probability of transferring nothing (1%) or more than $3 million (5%). The example illustrates that investment volatility in a long-term GRAT can undermine the benefit of a low 7520 rate for a GRAT s overall performance. Thus, the selection of the term and structure for the GRAT plan must compare the anticipated annual performance of the underlying assets (not just the total average return) to the applicable 7520 rate, as well as factor in the benefit of the mortality hedge afforded by shorter-term GRATs. With regard to short-term GRATs, as there is no clear authority for a one-year term, a series of two-year GRATs may be preferred. Further, it may be possible to achieve the economic equivalent of a one-year term by dramatically front-loading or de-escalating the GRAT s annuity payments. For instance, a two-year GRAT with a very large payment (e.g., 99%) in Year 1 with a payment in Year 2 that actuarially zeroes-out the GRAT may capture volatility better than a GRAT with a level annuity or an annuity that increases by 20% annually. Example: 8 Grantor contributes $10 million of single, U.S. large cap stock to a series of two-year rolling GRATs over a nine year period, assuming an average 7520 rate of 3%. End of Last GRAT Term 99% Front- Loaded Annuity Level Annuity GRAT Remainder $9,800,000 $8,700,000 4

5 While a series of short-term rolling GRATs may smooth out investment performance, they face the risk of future increases in the 7520 rate or the loss of the ability to complete the entire series of GRATs, if, for instance, tax law changes impose minimum GRAT terms (e.g., 10 years, as proposed by the Obama administration). Power of Substitution. If a GRAT provides the grantor with a nonfiduciary power to substitute or swap trust assets for assets of an equivalent value, the grantor can exercise this power to either bail out an underperforming GRAT or lock in the gains of an exceedingly successful GRAT. Example: Grantor created a 3-year, zero-out GRAT funded with 30,000 shares in X Co. At funding, the share price was $66 ($1.98 million total), and the 7520 rate was 1%. In Year 1, the shares increase in value to $83/share (almost 26%, for a total gain of $510,000). In Years 2-3, however, the share price falls and stays at $68 per share. Compare the outcomes if the grantor leaves the shares in the GRAT, or in Year 1, substitutes a bond portfolio with a 3% average return. End of GRAT Term Year 3 Substitution No Substitution GRAT Remainder $560,721 $143,260 Potential Estate Tax Savings (at 40%) $196,252 $50,141 Continuation of Grantor Trust Status. If at the end of the GRAT term, the GRAT remainder continues in a trust that is treated as a grantor trust for federal income tax purposes, the more the trust assets can grow without imposition of income-tax. 9 This growth can significantly increase the value of the GRAT remainder after the term. Example: A GRAT leaves a $500,000 remainder in a continuing trust for the remainder beneficiaries, and the grantor has a 25 year life expectancy. Assume a top federal ordinary income tax rate of 43.4% and a 23.8% long-term capital gains tax rate applies (both factoring in the 3.8% net investment income tax), and the trust has a 5% average annual return (70% ordinary income; 30% capital gain). If the remainder trust is taxed as a non-grantor trust, at the end of 25 years, the trust will have almost $1,079,000; if the trust continues as a grantor trust for that time, the trust hold $1,693,000, a $614,000 increase. TAKE-AWAYS GRATs, as a zero-gift planning strategy, currently benefit from their codified status and their unique flexibility with regard to term selection and annuity payment structure. Since GRATs only transfer an asset s appreciation, the technique s success relies heavily on the numbers, including the applicable 7520 rate, projected and actual investment returns on the trust, the availability of valuation discounts, the ability to backload annuity payments, etc. Thus, post-transaction management and performance reviews are critical to taking a GRAT plan to the next level. GRATs must be monitored annually to review the performance of the underlying assets, the potential risk of the grantor s death during the term, and the corresponding need to make changes to the investments, such as by exercising a power of substitution to lock-in existing growth. 5

6 SUMMARY: HIGHLIGHTED GRAT FEATURES & OPTIONS Feature/Option Description/Requirements Notes Annuity Stream to Grantor Required annual annuity payments, which may be set as a fixed dollar amount or expressed as a fixed percentage of the trust's initial value. A percentage formula will be preferable for hard-to-value assets (e.g., closely-held stock) since the annuity must automatically adjust to reflect later valuation changes (see below). Code Sanctioned Code 2702 and Treas. Reg Codification provides some certainty regarding tax treatment (e.g., as compared to other techniques, like sales to grantor trusts). No Gift Made/Required Upon Formation Estate Tax Exposure Investment Hurdle to Transfer Wealth Flexibility in Annuity Payments Flexibility in Term Length Automatic Valuation Adjustments Not GST Tax Efficient Specific Trust Provisions Required *Potential for Legislative Changes Not if the GRAT is zeroed-out. (i.e., present value of grantor s retained annuity stream equals the fair market value of assets transferred to the GRAT). Part or all of the GRAT assets are includible in grantor s estate if he or she dies during the term. Average trust growth must exceed the applicable 7520 rate to pass wealth to remainder beneficiaries Annuity payments can be structured to increase annually by up to 20% of the prior year s annuity payment. GRATs also can delay annuity payments for 105 days, keeping assets in the trust for additional compounding. Currently,* GRATs may be created for a term as short as two years or as long as the grantor s life expectancy. If the annuity is set as a fixed percentage of the trust s initial value, the GRAT must automatically adjust the annuity payments to reflect any subsequent valuation changes (i.e., by the IRS). A GRAT alone is not efficient for GST tax planning. GRAT agreements must comply specifically with Treasury Regulation requirements (e.g., no additions to the trust, prepayments to the grantor (commutation), or distributions to other beneficiaries during the term). Various legislative and budget proposals would require a minimum 10-year term and a possible a minimum remainder interest for GRATs Zeroed-out GRATs will be most efficient for gift and estate tax purposes. Taxable GRATs do not provide additional tax benefits and may waste federal unified credit. Funding with discounted assets can reduce the effective hurdle rate. Post-transaction monitoring and management of trust performance is also critical (e.g., considering whether to lock in gains by exercising a power of substitution). Increasing annuity payments (1) generally result in a larger remainder if appreciation is constant over the term, and (2) have appeal for GRATs involving illiquid property (e.g., closely-held stock). The GRAT can be funded with cash to meet the smaller initial annuity payments until the expected liquidity event. Allows for the use of a series of short-term rolling GRATs that may hedge against poor initial investment performance. Particularly pertinent for planning with hardto-value or discountable assets (e.g., real property, closely-held stock) as the IRS continues to challenge the use of formula clauses in other planning techniques (such as direct gifts and sales to grantor trusts). Must combine with other planning to implement a GST-tax efficient plan. Non-compliance may result in a gift tax on the entire contribution. Enactment would increase the GRAT s estate tax exposure risk and eliminate the ability to create GRATs without imposition of gift tax. 6

7 DISCLAIMER In order to comply with requirements imposed by the IRS which may apply to the Washington Report as distributed or as re-circulated by our members, please be advised of the following: THE ABOVE ADVICE WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, BY YOU FOR THE PURPOSES OF AVOIDING ANY PENALTY THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE. In the event that this Washington Report is also considered to be a marketed opinion within the meaning of the IRS guidance, then, as required by the IRS, please be further advised of the following: THE ABOVE ADVICE WAS NOT WRITTEN TO SUPPORT THE PROMOTIONS OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE, AND, BASED ON THE PARTICULAR CIRCUMSTANCES, YOU SHOULD SEEK ADVICE FROM AN INDEPENDENT TAX ADVISOR. The AALU WRNewswire and WRMarketplace are published by the Association for Advanced Life Underwriting as part of the Essential Wisdom Series, the trusted source of actionable technical and marketplace knowledge for AALU members the nation s most advanced life insurance professionals. WRM #14-08 was written by Greenberg Traurig, LLP Jonathan M. Forster Martin Kalb Richard A. Sirus Steven B. Lapidus Rebecca Manicone Counsel Emeritus Gerald H. Sherman Stuart Lewis NOTES 1 See Internal Revenue Code ( Code ) 2702 and Treas. Reg Note that the grantor does not need to pre-fund the GRAT with a separate gift, unlike installment sale transactions to grantor trusts, which may require a gift of so-called seed money (typically 10% of the value of the assets sold) to evidence the trust s ability to make payments under the installment note. 3 See Carlyn S. McCaffrey and John W. Porter, GRATs - Current Issues Regarding Creation, Maintenance, and Operation, 40th Annual Heckerling Institute on Estate Planning, Special Session I-B, Jan. 15, Treas. Reg (b)(4) requires that the annuity must be paid no later than 105 days after the anniversary date of the creation of the trust if the annuity is payable based on the anniversary date and no later than the date on which the trustee must file the trust s income tax return (determined without extensions) if the annuity amount is payable based on the taxable year of the trust. 5 See Treas. Regs (b)(2) and (a)(1)(iii). 6 See Jonathan G. Blattmachr and Diana S.C. Zeydel, Playing the Tables: Current Developments in GRATs, SCINs and Other Wealth Transfer Strategies. 7

8 7 See example and discussion in Steve R. Akers, Transfer Planning, Including Use of GRATs, Installment Sales to Grantor Trusts, and Defined Value Clauses to Limit Gift Tax Exposure, State Bar of Texas Advanced Estate Planning Institute, June 12, See example and discussion from Diana S. C. Zeydel and Robert A. Weiss, Anticipating the Mathematics of Planning Gifts Under Current Law -- Using Shelters, the Impact of Portability, Structuring GRATs and More, American College of Trusts and Estates Counsel 2011 Summer Meeting, June 22-25, Of course, the continuation of grantor trust status must consider the financial impact to the grantor, who will continue to pay the trust s income tax burden. Thus, the remainder trust should allow for the turning-off of grantor trust status during the grantor s lifetime, in the event the tax burden becomes economically impractical for the grantor to bear. 8